Principles Based Regulation
A discretionary based approach to regulation, whilst encouraging greater possibilities for regulatory capture, appears to be more congruent with principles based regulation. However it is possible to implement a system of regulation which combines increased formalised procedures and/or detailed rules - whilst giving due consideration to the substance of transactions.
“Principles provide the framework in which firms can organize their own processes to achieve the outcomes the regulator seeks – the regulator in turn, depends on firms to adopt an attitude to the regulatory regime (which is one which aims to go beyond minimal compliance with rules).”139 Principles based regulation is not only advantageous because it allows management of a bank or firm to take into consideration the substance of transactions, but because “principles impose
Supervision 1998
134 ibid
135 See „The Relationship between Banking Supervisors and Banks’ External Auditors January 2002 paragraph 40 page 11 <http://www.bis.org/publ/bcbs87.pdf?noframes=1>
136 See Framework for Internal Control Systems in Banking Organisations, Basel Committee for Banking Supervision 1998 at page 23
137 ibid at page 20.
138 ibid
139 See J Black, „Forms and Paradoxes of Principles Based Regulation“ LSE Law, Society and Economy Working Papers 13/2008 (2008) at page 9 http://www.lse.ac.uk/collections/law/wps/wps.htm and
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outcomes to be achieved – not detailed processes for achieving them.”140 As well as being linked to meta regulation, principles based regulation facilitates a system whereby principles “communicate regulatory objectives and promote behaviour which will achieve those objectives.”141
Principles based regulation, thus, would not only reduce the scope for “creative compliance” – since the substance of transactions should be considered by management, but also has the benefit of providing a more flexible and responsive approach to regulation as the subsequent section will seek to demonstrate.
Principles based regulation is considered to comprise of 3 elements, namely:142
• A particular type of rule
• A focus on outcomes and
• A focus on senior management responsibility in ensuring these outcomes are achieved
Furthermore, three forms of principles based regulation, namely: “formal principles based regulation; substantive principles based regulation and full principles based regulation”, have been suggested.143 For the purposes of this paper, focus will be restricted to substantive principles based regulation.
Five classes of regulatory practices which could characterise substantive principles based
regulation include:144 “The particular mode of interpretation- that is, the approach taken in the interpretative process; particular enforcement style; an orientation to outcomes; a relocation of responsibilities for working out the practical application of the provisions; and an explicit and developed reliance on management based regulation.”
The effectiveness of rules and regulation is dependent, not only on the monitoring processes and tools used in such processes, but also the effectiveness of the enforcement of those rules. For this reason, focus will be dedicated to the second characteristic of substantive principles based regulation– which is indeed a “critical” and defining feature of principles based regulation.
According to Black, the adoption of the “responsive” enforcement approach is justified on the basis that “neither negotiative approaches nor deterrence based approaches are effective on their own and that instead, regulators should implement a mixture of both, that is, first negotiate, then if the firm still does not deliver substantive compliance, regulators should gradually move up the enforcement pyramid, applying sanctions of increasing severity until it does.”145 She adds weight to Baldwin’s argument146 by stating that “those who know what they are meant to be doing and are generally inclined to do it (“the well intentioned and well informed”) , are best dealt with using a negotiating strategy – which is easier to do using principles. In contrast, those who do not know what they are meant to be doing and even if they did, would not be inclined to do it (“the ill intentioned and ill informed”), are best dealt with using a strategy that escalates rapidly up the enforcement pyramid.”147
140 ibid
141 ibid at page 16
142 See J Black, „Forms and Paradoxes of Principles Based Regulation“ LSE Law, Society and Economy Working Papers 13/2008 (2008) at page 12
143 ibid
144 ibid at page 17
145 See also I Ayres and J Braithwaite, Responsive Regulation (1992) Oxford University Press
146See R Baldwin, Rules and Government (1995) Oxford : Clarendon Press
147 J Black, „Forms and Paradoxes of Principles Based Regulation“ LSE Law, Society and Economy Working Papers 13/2008 (2008) at page 19; She argues that “in a regime with a tough, punitive approach in which every infraction is met with a sanction, principles based regulation (PBR) would not survive – this being the case, because there is greater
This “responsive” approach, it is further argued, “is not contingent on any particular rule design and can operate in systems of i) highly detailed rules, ii) where the rules are mainly principles, iii) where there is a combination of both.”148
Having considered the forms, attributes and benefits of principles based regulation, the weaknesses inherent in this type of regulation are worth mentioning. Firstly, in relation to the all important aim of ensuring accountability – which should be fostered if adequate monitoring procedures are observed and carried out by the responsible levels of authority. Principles based regulation could serve as a hindrance towards ensuring accountability. In this respect, reference will be made to the seven paradoxes of principles based regulation – which are as follows:149
“i) The interpretative paradox : Different interpretations attributed to principles could result in imprecise and general terms being accorded very specific interpretations – even though principles are supposed to offer flexibility (where these are characterised by imprecise terms).
ii) The communicative paradox: Principles, whilst facilitating communication, could also hinder such communication. The paradox is attributed to the distinction between legal use of language and its ordinary use.
iii) The compliance paradox: Principles provide scope for flexibility in compliance – however this could result in conservative and/or uniform behaviour by regulated firms.
iv) The supervisory and enforcement paradox: Principles require enforcement to provide them with credibility – however over-enforcement could result in their demise.
v) The internal management paradox: Principles based regulation has the potential to offer required flexibility for internal control systems to develop – and also the potential to overload them.
vi) Ethical paradox vii) Trust paradox
A detailed consideration of the above mentioned paradoxes highlights the importance of having a clear understanding of the form of principles based regulation which is applicable to a particular bank or business. As highlighted under the substantive principles based regulation, “those who know what they are meant to be doing and are generally inclined to do it ( the well intentioned and well informed), are best dealt with using a negotiating strategy.” Hence a more draconian mode of enforcement , that is tougher sanctions, would not be best suited in facilitating compliance by such groups – such sanctions being better reserved for the “ill informed and ill intentioned.”
Furthermore, a tough punitive regime is one in which principles are unlikely to survive – even though detailed rules could still be implemented under principles based regulation.150
Hence the desired level of compliance required within a firm is best achieved having regard to the organisational structure which exists within an organisation – and to whether (as a result of a such determination), that organisation could be considered a suitable candidate for the application of principles based regulation. Clear delegation and segregation of duties within an organisation would not only promote accountability, but would also facilitate a system where principles could be
risk that firms will make the wrong assessment ie one with which the regulator does not agree.” Under principles based regulation, she argues further, “firms are required to think through the application of the provisions to particular situations to a far greater degree than they are with respect to a detailed rule – hence the higher probability that firms would make the wrong assessment .” See ibid at page 18
148 J Black, „Forms and Paradoxes of Principles Based Regulation“ LSE Law, Society and Economy Working Papers 13/2008 (2008) at page 19; It is further argued that “Different rule types make it easier for regulatory officials to deal with certain types of regulated firms.”
149 See ibid at pages 25 -35
150 Refer to Formal Principles Based Regulation; ibid at page 12
applied and also facilitate monitoring procedures. Consequently, monitoring would also facilitate accountability – since frequent reviews and discussions between management and appropriate personnel should increase an understanding of the activities carried out by particular divisions within the organisation.
H. CONCLUSION
Monitoring fosters transparency, which in turn fosters accountability. Monitoring of key risks, as well as periodic evaluations by the business lines and internal audit constitute a vital element of corporate governance – hence the overall effectiveness of a bank’s internal controls should be monitored on an ongoing and frequent151 basis.152
Since it is possible for detailed rules to operate under principles based regulation – and since detailed rules constitute a vital element in ensuring that clear delegation and segregation of responsibilities exist within an organisation, it could be said that the level of accountability derived under principles based regulation is dependent on the form of principles based regulation. Under the formal principles based regulation, the level of accountability derived is likely to be greater than that derived under full principles based regulation. As highlighted within the relevant sections of this paper, an approach which combines negotiating and punitive strategies is always considered best – owing to the level of flexibility offered by such an approach. However the organisational structure, culture and several other factors require consideration before substantive principles based regulation is judged to be the optimal approach.
In accordance with Principle 13 of the Principles for the Assessment of Internal Control Systems,
“supervisors should require that all banks, regardless of size, have an effective system of internal controls that is consistent with the nature, complexity, and risk inherent in their on- and- off balance sheet activities and that corresponds to the bank’s environment and conditions.” Furthermore, “in those instances where supervisors determine that a bank’s internal control system is not adequate or effective for that bank’s specific risk profile, they should take appropriate action.” In accordance with Core Principle 17 of the Basel Core Principles for Effective Bank Supervision, Internal controls and audit, specific attention should given to ensure the existence of: i )“clear arrangements for delegating authority and responsibility; (ii)separation of the functions that involve committing the bank, paying away its funds, and accounting for its assets and liabilities.”
Where clear delegation of authority, segregation of responsibilities are not in place, the most appropriate and obvious action might be to initiate a more deterrence based approach – rather than a negotiative based approach. However, reference must be made to factors highlighted under the first paragraph of this conclusive section.
Increased formalisation under principles based regulation would still allow for a consideration of
151 “The frequency of monitoring different activities of a bank should be determined by considering the risks involved and the frequency and nature of changes occurring in the operating environment.” See Framework for Internal Control Systems in Banking Organisations at page 20 http://www.bis.org/publ/bcbs40.pdf
152 See also Principle 10 of the Principles for the Assessment of Internal Control Systems; Framework for Internal Control Systems in Banking Organisations at page 20 http://www.bis.org/publ/bcbs40.pdf. “Monitoring the
effectiveness of internal controls could be undertaken by personnel from several different areas, including the business function itself, financial control and internal audit. For that reason, it is important that senior management clarify which personnel are responsible for which monitoring functions.” Further, “monitoring should constitute part of the daily activities of the bank – whilst including separate periodic evaluations of the overall internal control process. ”;ibid
the substance of transactions – whilst allowing for flexibility in terms of its application. With regards to its application, this implies its suitability as the appropriate mode of regulation - based on the level of accountability it could provide an organisation with and whether an organisation, because of its structure and culture, should consider applying it at all.